TOKYO -- With the gap in inflation between the U.S. and Japan widening, a growing chorus of foreign exchange market participants is pointing to the possibility of a significant rise in the value of the yen over the medium to long term.
Changes in consumer prices in the two countries reveal a surprising disparity: Over the past 20 years, the gap has widened by more than 50%. While prices in the U.S. continue to rise, those in Japan remain almost flat, the country having gone through a long bout of deflation.
Typically, countries with higher inflation see their currencies depreciate relative to those with lower inflation based on the concept of purchasing power parity -- the theory that a basket of identical traded goods will cost the same everywhere, with a currency rising or falling in value until relative prices equalize across countries.
In 1998, the dollar traded at around 140 yen, versus about 110 yen now. Although the yen has appreciated over time, its actual purchasing power is not fully reflected in the current exchange rate. Based on the price differential between the two countries, a rate in the lower 90-yen range is theoretically possible.
The real exchange rate for any pair of currencies is the nominal exchange rate, adjusted for price differences in the two countries. Say the yen rises by 20% against the dollar, when an increase of 30% is expected given the price differential between the two countries. In such a case, the yen would be 10% undervalued against the dollar.
The real effective exchange rate measures the real exchange rate of a country's currency against a basket of its trading partners' currencies. The real effective exchange rate offers a more precise measure of a currency's actual value, and the impact on trade of any change, than the nominal rate.
"Generally, the real effective exchange rate fluctuates over time, but returns to its long-run average," said Shingo Ide of NLI Research Institute. Ide believes that while exchange rates may temporarily fail to reflect shifts in a currency's actual value in the short term, this will not be true over the long haul.
In June 2015, when the real effective exchange rate of the yen fell near its historical low versus its 20-year average, Haruhiko Kuroda, governor of the Bank of Japan, declared a further depreciation of the yen unlikely.
However, the yen's real effective exchange rate remains low. "In terms of the real effective exchange rate, the yen is the cheapest currency among major countries," according to Daisuke Karakama of Mizuho Bank.
Conversely, the real effective exchange rate of the dollar remains around 10% higher than its 20-year average. This is the source of U.S. President Donald Trump's complaints about an overvalued greenback.
The U.S. Treasury Department's "Semiannual Report on International Economic and Exchange Rate Policies" tends to use the real effective exchange rate as its yardstick. The April report pointed to an excessive depreciation in the yen, saying the currency's real effective exchange rate was nearly 25% below its 20-year average.
Japan's merchandise trade surplus with the U.S. accounts for less than 10% of the U.S. trade deficit, compared with about 50% for China. That makes China a bigger target for U.S. ire. But there is a good chance the U.S. may eventually turn its attention to Japan, given that the yen is severely undervalued.
Regarding Japan's real effective exchange rate, some observers say it has been low for about five years, having failed to return to its long-run average. But they argue this is due to a decline in Japan's international competitiveness, and thus the long-run average is no longer a good benchmark for the yen's proper level.
There are several factors working against an appreciation of the yen. One is Japanese companies' focus on overseas production. Another is monetary policy. Over the last five years, Japan's central bank has pursued aggressive monetary easing under Kuroda. At the same time, the world economy has continued to expand, putting further downward pressure on the yen, which tends to be sold when investors are feeling bullish -- a "risk-on" environment.
But it would be risky to think that the current situation is permanent. When might the yen begin surging?
"The U.S. will gradually raise interest rates close to a level that could cool the economy," said Mizuho Bank's Karakama. "That would, at the same time, prompt capital outflows from emerging markets and eventually result in a 'risk-off' environment. In this scenario, the yen's value may well be drastically corrected."